Econ 101: Interest Rates and Credit

Interest rates play a major role in our economy. We often hear of the Federal Reserve Bank raising or lowering interest rates in an effort to stimulate the economy and reduce unemployment in bad times, or to try and “slow the growth” in good times. I’ll attempt to explain how that works in a future post, but for now, I want to focus on what interest rates are and why they matter.

To put it as simply as I can, interest rates are the price of money. More specifically, an interest rate is the price you pay in the future for money you get now. If I go to the bank and ask for a loan of $1000 at 10% interest to be paid off in one year, that means that they give me $1000 now in exchange for $1100 later, specifically a year from now. This transaction is mutually beneficial because of our different “time preferences.” In this instance, I prefer to have a smaller amount of money as long as I can have it right now, and the bank prefers to have a larger amount of money and doesn’t mind if they have to wait until later to get it. Similarly, when you deposit money in a savings account that earns interest, you are granting the bank the use of your money now in exchange for some additional money that gets paid over time.

Although some of us manage to be savers, these days interest rates enter our experience most commonly through our use of credit. Credit dominates our economy in big and small ways, from multimillion dollar construction loans to packs of gum bought with a credit card at the grocery store. As the Law of Demand would suggest, as interest rates get lower, other things being equal, we tend to find that credit is used more frequently, with people borrowing money in larger amounts and doing so more often. They tend to charge things to credit cards more readily as well since the price of repayment is relatively low. As interest rates increase, we tend to find that people save more because they can get a higher price for their money, and they tend to use credit cards less often.

I’ve left out a great many aspects of Economics in these posts due to space and time concerns, but I wanted to cover what I consider to be the basics. In the next few articles, I’m going to be applying these basic concepts to the role of unions, government, and the banking system to show the effects of these institutions on the economy.